Portfolio effects of debt-equity swaps and debt exchanges with some applications to Latin America

Voluntary debt reduction schemes (VDR), such as debt-equity swaps (DES) or collateralized debt conversions (CDC), are bound to play a relevant role in the foreign debt strategy of highly indebted countries (HICs). This paper assesses the impact of VDR on domestic macroeconomic variables. More specifically, it evaluates the impact of DES and CDC on inflation, equity prices and on sovereign debt prices. For that purpose a short-term portfolio balance model with domestic and foreign assets/liabilities is formulated. A distinctive feature of the model is that all current transactions take place at end of period prices. The model supports the view that DES are inflationary, and indicates that in the short-term, DES and CDC are likely to raise equity prices and sovereign debt prices. This paper shows that the impact of DES on sovereign debt prices depends on a host of factors: the expected trade surplus; the stocks of debt and foreign-held equity; the redemption price of debt; restrictions on profit remittances; the physical rate of return on equity; and the technology that determines it. A discussion regarding the dynamics of adjustment to the steady state illustrates possible linkages between DES subsidies, rates of return and investment levels. The paper concludes with a parametrization of the conditions under which DES can lead to higher debt prices in selected Latin American countries.